Somaliland:Attributes of SL Shilling Deterioration

ATTRIBUTES OF SOMALILAND SHILLINGS DETERIORATION AND THE DISAPPEARANCE OF SMALLER DENOMINATIONS

Abstract

The self-declared republic of Somaliland has printed its own currency in 1994 for the first time. From that moment Somaliland shillings has met continuous devaluation. It faced harsh times which resulted extreme depreciation and exchange rate fluctuations. This paper deals with the factors accelerated the exchange rate of $1from 50 to 6000 SLSH. In addition, factors eliminated the smaller denominations of SLSH will be explored.

Introduction

The exchange rate is the price of one currency stated in terms of another currency. Exchange rate systems can be classified into three fundamental categories; fixed exchange rate, floating (flexible) exchange rate, and managed exchange rate. In a fixed exchange rate system, the value of a nation’s money is defined in terms of a fixed amount of another currency. On the other hand in a floating exchange rate system, the value of a nation’s money is allowed to float up and down in response to the market forces. In a managed exchange rate system, the central bank only intervenes under special circumstances when it wants to influence the exchange rate one way or the other. Whenever exchange rate changes, certain currency is appreciated or depreciated. Appreciation is an increase in a currency’s value. This means it buys more units of another currency. Depreciation is a decrease in a currency’s value. It buys fewer units according to another currency. Appreciation of a currency is caused by an increase of demand of domestic goods relative to the foreign goods, Tariffs and quotas, Export demand increase, Productivity and Demand of money. On the other hand, depreciation of a currency is caused by import demand increase, Inflation and Money supply.

Central bank issues the country’s currency and manages its circulation. If the country uses fixed exchange rate system, central bank sets the rate. In the floating exchange rate system, market forces control the rate. However, the central bank should regulate the exchange rate through money supply. Central bank also manages the reserves of foreign currency; moreover it protects the value of local currency.

Causes of Somaliland Shillings depreciation:

Background of Somaliland exchange rate

Since the introduction of Somaliland notes and mint coins, the value of the currency has been declining almost every year – except a year or two it has appreciated compared to the preceding year- in dramatic rates in some years and in moderate in others. The economic system of Somaliland in urban residence is market economy, thus the exchange rate in the country is primarily determined by the amount of Somaliland shilling and foreign currency (dollar) in the market.

At the beginning Somaliland currency was not accepted in the country as a whole, in fact part of the capital city, Hargeisa, didn’t recognize its validity. The initial printed quantity- which was 10 (ten) billion Somaliland shillings- was huge considering the supply of foreign currency (dollar) and functional geographic area of Somaliland shilling, a week later the initial government rate was forced to increase, allowing itself to correct automatically. Inseparability of Central Bank laws and the right to use the printed money by the central government and uncontrolled pumping of shillings to the market has exacerbated the matter further, leading the shilling to lose value in greater rates.

The civil war which broke out in different regions of the country forced the government to use illegally the money in the Central Bank to finance its war against clan insurgents and clan leaders whom the governing administration- as well as later administrations- exploited to disarm the rebels and to put to an end of the civil war.

The massive use of money for military and political purposes enlarged the supply of shilling in the market, which resulted, an enormous decline of shilling value never been witnessed in preceding years.

It became a pattern that each administration prints and uses money whenever it needs- deficit and debt finance- without having in mind a monitory policy to follow. The illegal exploitation of the numerous shillings by the government makes the currency worthless. Every time the government prints money is like imposing tax on goods and services by the amount printed, this will precipitate the collapse of little value left of the currency and make life unbearable in Somaliland in the near future.

The question to be answered is, was it or will it be rational economically to pay this tax.

Knowing the initial rate of shilling per dollar was two digits of Somaliland shilling (50 shilling per dollar), another question is to be answered. How Somaliland shilling ended up that a single dollar is worthy thousands of Somaliland Shilling?

Civil war

As soon as the Somali National Movement (SNM) liberated the northern regions of Somali Republic, the people of Somaliland announced that they regained their independence from the rest of Somali republic. Several civil wars started some areas in Somaliland during the early years of the new state. However Somaliland managed to have its own currency (Somaliland Shillings) as early as 1994. Unfortunately, when 50% of the currency went into circulation, the most influential civil war broke out in Hargeisa, the capital city of Somaliland. Since the government was financially very weak due to absence of tax collection mechanism as well as other sources of government revenue, the rest 50% of the printed money was financed to war. Obviously when there is a war large funds should be available in order to use during the operations. There were no government reserves because the infant government could not even collect the tax. In addition, there was no foreign aid or other reserves since the self-determined government was not recognized by any country and the entire Somali republic was collapsed as well.

Although the whole printed money was put into circulation, the other important thing which has to be mentioned is that it was completely converted into USD since the Somaliland shillings was not accepted in several regions and districts. At that moment, the central bank had no sufficient reserves of US Dollars which could be pumped into the markets in order to protect the value of the local currency. This resulted for unbalanced money supply and then the value of Somaliland currency went down. After those civil wars the government started to solve the conflicts between clans and to disarm the militants. This is also caused same problem. Consequently, when large amount of printed money was pumped into circulation without equivalent reserves of USD, the Somaliland shillings depreciated extremely.

Large amount of imports and fewer exports

Large amount of imports and fewer amounts of exports are also vital factors and contributed a lot to the depreciation of SLSH. In Somaliland most of consumers and capital goods are imported from overseas by local tycoons. Importers buy their goods from foreign countries in dollar, because there is no Somaliland currency reserve and/or banks having relations with Somaliland commercial bank. Even though Somaliland parliament passed commercial banks law, there are no international or foreign commercial banks establishing branches in Somaliland.

Importers transfer money to their customers through Somali-remittances like Dahabshiil. More demand of dollar from imports coerced to the importers to resell their goods in dollar as well as distributors which brought to decrease the demand of Somaliland shilling according to foreign currency (dollar). Eventually imports are one of the factors those caused the depreciation of the value of shilling.

Lack of recognition brought to Somaliland currency excluding international transactions that caused less demand of Somaliland currency. Somaliland shilling does not include the currencies which are recognized by IMF (International Monetary Fund).

The relationship between the level of output and the real exchange rate is an important and controversial issue for economies. Economists have been studying correlation between the real exchange rate and the level of output because currency depreciation is often considered to be a tool for improving the foreign sector of an economy.

It is argued that a devaluation or depreciation of currency raises the price of imports in comparison to that of its exports, and this causes the trade balance to improve.

This leads to an improvement in the foreign sector of economy. The improvement in the foreign sector raises output and employment in the overall economy. This does not exist in Somaliland; Somaliland currency depreciated and not brought to improve the foreign sector because of many factors.

Less output

less export

Lack of recognition

Somaliland currency is absent from international transactions.

Furthermore, there are no more foreign exporters in Somaliland, but some livestock exporters who buy livestock in dollar that deteriorates Somaliland shilling according to dollar. In addition, Somaliland government is not strong government to protect Somaliland shilling and has no strong central bank responsible for monetary policy to control the exchange rate effectively. These factors lead to decrease the demand of Somaliland shilling and increase the demand of foreign currency (dollar).

Finally these factors we have discussed above are some of the factors attributed the depreciation of Somaliland shilling according to dollar.

Absence of tax collection mechanisms

There is an undisputed fact that all governments spend money to buy goods and services. Any government can finance its spending in three ways. First, it can raise revenue through taxes such as income tax or property tax. Second, it can borrow from the public. Third, it can print money.

In Somaliland, the liberation war caused massive destruction in the country as a whole and properties in particular; it forced citizens to flee the country and lived in camps in Ethiopia, where the government institutions, services, and ability to raise tax revenue disappeared too. After the declaration of the independence of Somaliland the newly formed government unfortunately lacked the ability to collect tax, since it had no sources of revenue to cover its expenditure on the new administration, forces, security, and equipment. Borrowing form merchants was a way out to meet these expenditures. For the first three years the government depended on deficit financing but the burden of debt persisted, solution to tackle the issue and find a way to cover the expanding expenditure was inevitable.

Three years from the announcement of the independence of the country, a new currency notes and coins special for Somaliland was printed, for the purpose of replacing the former currency of Somalia. Through the printed money it generated revenue –called senior age – and met some of its debt obligations and covered government expenditure.

Yet the worst was to come, civil war broke out nearly everywhere in the country and the need of money was more than ever before. Moreover territory under government control was suffocated and no one was willing to pay tax. The easy way to raise revenue was printing money for financing the war against the rebel and enforces law and order in the country.

Today, neither the civil war nor the inability of the government to raise revenue through taxes is present; the question to be answered is why in this modern world the government is still relying on senior age?

Squeezed territory of shilling functioning

Though many factors are attributed the inflation of Somaliland, squeezed functioning is one of that. This is the consequence behind the civil wars that Somaliland shillings to be functioned in small area of Hargeisa and people in Somaliland did not believe and use all. This led a huge amount of money to be functioned in small area whereby small population lived. So everyone has got an access to more money and the government used illegally while also it didn’t expand to all the regions and districts of Hargeisa. When the huge money was put and functioned in small area, it did not match the people and doubled two or three times and ultimately it depreciated.

On the other hand the amount of dollars and the Somaliland shillings were not balanced because there were few dollars relative to Somaliland shillings and the Somaliland shillings depreciated. When the taking of Somaliland shillings was too heavy, people exchanged small dollars and people are afraid to hold Somaliland shillings because it was depreciating day after day and no longer to be held.

Low GDP and Expanding Money Supply

The quantity theory of money explains the relationship between money supply and real GDP. M*V=P*Y where M is money supply, V velocity of money P price of goods and services and Y is output. PY is nominal GDP and velocity of money is inversely related to the GDP, an increase of money supply results velocity of money to approach to one or constant. If money supply increases one or both of the right-side components of the equation must increase to keep the balance of the equation. Somaliland GDP was at the bottom when the Shilling was printed forcing prices to increase in tremendous rates, and increase in prices means inflation

Inflation should be nothing more than the rate of the increase of money supply less the increase of the rate of productivity which should normally drive prices down. Unfortunately the country was recovering from the devastation of civil war; output was too low to drive the increasing prices down which caused by the ever expanding money supply, one features of inflation is it erodes the value of money, in other words people will need more money to pay for the same good or service.

In conclusion money supply can be curse or bless, for the case Somaliland it is the worst curse the economy has dealt with and still dealing with. Money is a good thing and can increase the quality of the lives of people who have it, but only if there is money to be held during a period when people are producing enough goods or services able to increase their lives’ quality. So, it should be the goal of any government, in their pursuit of managing inflation and unemployment, to attempt to keep money supply within a range of proportions attached to the national production.

Factors eliminated the smaller denominations of Somaliland shillings from the market:

Inflation

Obviously increase in the general level of prices affect the value of the currency. When prices of goods rise, people must pay large amount of money for those goods. Therefore the value of currency decreases according to those goods.

Somaliland experienced the most severe inflation during two decades of weak government. Since prices of all goods and services are based on US Dollars, this inflation affects the house holds directly. Moreover continuous increase of prices resulted frequent depreciation of the currency. Eventually the smaller denominations became useless, as they became value less.

Transaction cost

Transaction cost occurs whenever a good or service is transferred from a provider to a user. One of the major facilitators of economic or business transaction is money. In other words it minimizes the time taken for any transaction between two people to be completed.

For the smaller denominations of Somaliland currency, conducting one of the simplest transaction e.g. bus fares takes more than five minute for every person’s fare to be counted and more complex transactions such as purchase of a car may take more than a day. Small denominations of Somaliland currency are still legal notes to be used in payments but the reason they are no longer in use is the time taken to carry out a business transaction with it.

Loss of purchasing power of the currency

As mentioned earlier the excess deployment of money to the market causes the currency to lose value, because there is more money relative to the amount of available goods and services which will cause the depreciation of the money in circulation. Keeping money supply correlated to the nation’s gross national product may preserve the purchasing power of the currency and keep the money alive.

Portability

One important character of money is to be easily portable, that means the money shall not be inconveniently heavy on the one hand, many of the substances used as currency in former times must have been sadly wanting in portability. The portability of money is an important quality not merely because it enables the owner to carry small sums in the pocket without trouble, but because large sums can be transferred from place to place, or from continent to continent, with less costs. Somaliland currency has been losing value since its first printing age, exchange rate went down extremely, that resulted exchange of one dollar to be converted to large amounts of Somaliland notes, which is problematic to consumers to carry easy in hand or in pocket. This led small notes to lose purchasing power and finally the whole smaller notes left out the market.

Conclusion

To sum up, all the problems discussed above are the results of weak central bank. The government as a whole and the central bank in particular neglected to protect the value of the nation’s currency. Monitory policy is one of the most important tools to keep the economy healthy. Central bank is responsible for formulating sound monitory policy. Another challenge of Somaliland shillings is locally produced products priced in US Dollars which exacerbate the matter. The worst of all is the government dependence on printed money to finance deficits or to balance the budget. Money is a good thing and can increase the quality of the lives of people who have it, but only if there is money to be had during a period when people are producing enough things able to increase their lives’ quality. After two decades since the SLSH was printed, the fourth government of Somaliland is apparently taking the same way. There is no functioning central bank so far, to save the local currency and to formulate sound monetary policy to put this problem to an end.

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